CareFusion Corporation (NYSE:CFN)
Q3 2014 Earnings Conference Call
May 5, 2014 5:00 p.m. ET
Kieran T. Gallahue - Chairman and Chief Executive Officer
James F. Hinrichs – Chief Financial Officer
Jim Mazzola - SVP of Global Marketing, Communication and Investor Relations
Michael Weinstein – JPMorgan
Rick Wise – Stifel Nicolaus
David Roman – Goldman Sachs
Robert Hopkins – Bank of America Merrill Lynch
David Lewis – Morgan Stanley
Matt Miksic – Piper Jaffray
Lawrence Keusch – Raymond James
Good day, ladies and gentlemen, and welcome to the Third Quarter 2014 CareFusion Corporation’s Earnings Conference Call. My name is Denise, and I’ll be the operator for today. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions)
I will now turn the presentation over to your host for today’s call, Mr. Jim Mazzola, Investor Relations. Please proceed.
Thank you, Denise and thanks for joining everyone. On today’s call, Kieran and Jim are going to discuss CareFusion’s results for the third quarter ended March 31 of 2014, as well as provide an update on our outlook for fiscal 2014. We issued a news release about an hour ago with our financial results, which is posted on our website at carefusion.com. We also posted a slide with our current financial guidance. The news release, our financial table and the guidance slide were filed on Form 8-K with the Securities and Exchange Commission today earlier at 12:00.
Please note that during today’s call, we will discuss non-GAAP financial measures, including results on an adjusted basis. We believe these adjusted financial measures can facilitate a more complete analysis and greater transparency into CareFusion’s ongoing results of operations, particularly in comparing underlying results from period to period. Before I turn the call over to Kieran, I’d like to remind you that during today’s call, we will be making forward-looking statements, including statements about our fiscal ’14 guidance. Our actual results could differ materially from those expressed in our forward-looking statements due to risks and uncertainties, including the risk factors set forth in today’s release and our filings with the SEC.
With that, I’ll turn the call over to Kieran.
Thanks, Jim. Good afternoon, everybody, and thanks for joining us. During our third quarter, we continued to make progress across all our business lines. Some of this progress is evident in the income statement or our statement of cash flows and some of it comes through metrics that we track, like committed contracts and our backlog. Across each business, momentum is building and we are encouraged by the progress that we’re making.
In the Procedural Solutions segment, we saw strong growth of 25% and marked nearly two years of consecutive quarterly organic growth in the mid to high single digits. This organic growth continues to be led by the performance of our clinically differentiated products, including PleurX for chronic drainage, ChloraPrep for skin preparation and our MaxGuard infusion valves.
Our Infection Prevention business which includes our skin prep products and Infusion Specialty Disposables grew 12% and Medical Specialties business, which includes our surgical instruments and interventional specialties products, grew 3%.
In our Specialty Disposables business, organic growth of 5% was driven by the product lines we represent in the U.S. for Smiths Medical and Fisher & Paykel. In addition, much of the reported growth of this business came from our Vital Signs acquisition, which continues to integrate well within CareFusion. We are seeing the benefits of the capabilities that we developed through our spinoff and our three-year initiative to simplify CareFusion. Integration has become a core competency and it shows in our work with Vital Signs.
To-date, we have closed with GE on all but the last few geographies and we are ahead of schedule with our deal model. Our sales teams are working well together as we build scale and focus on the Anesthesia call points. And we recently began the process to consolidate Vital Signs’ U.S. manufacturing and support operations into existing CareFusion facilities; a transition that will occur over the next two years. I'm very impressed with the Vital Signs team that has joined CareFusion and pleased with the progress we have made in the two quarters since we announced the acquisition.
In the Medical Systems segment, we had another strong quarter of committed contracts in the dispensing and infusion businesses, with excellent momentum building with the rollout of our Pyxis ES platform. I want to highlight a few key points about where we stand with the ES rollout. Number one, Pyxis ES comprised more than 50% of our dispensing committed contracts during Q3 and the system continues to be very well received by customers. We have rollouts underway at literally hundreds of hospitals with a strong and growing number of reference accounts now realizing the benefits of the system.
Number two, we have nearly a full install schedule entering the fourth quarter and have made good progress on our installation process. Each day, our process becomes more standardized with dedicated resources to make the experience a positive one for our customers. We will not rush these installations because we won't settle for anything less than a great customer experience.
Number three, with the progress we have made, I feel very good about the forecast for the fourth quarter. We always said installation timing would be the most unpredictable variable in our guidance for the back half of the year. To be frank, I think we could have done more of a thorough job in anticipating the length of time it would take to reengineer the complex processes we are now automating with the ES platform. As a result, we were not as accurate as we could have been in building your quarter-to-quarter expectations. That said, our team has responded well and we turned the corner in Q3. As a reminder, this business operates largely on a lease model. So our cash flow has remained strong during this transition due to the predictable monthly payments from our large and stable customer base.
Number four, we have built our largest backlog ever and it continues to grow. This is a positive indicator of future revenues. As we said last quarter, the system is being adopted, the benefits are understood and we are aligned with our customers on a vision for medication management. With the progress we've made on the installation process, we will have good momentum as we enter fiscal year '15. To summarize, we’re in a great position with the Pyxis ES transition. We have a better approach to medication management that is tightly integrated with our customer systems and they are now realizing the benefits.
Closing out the Medical Systems segment, I don’t want to overlook the strong performance this year of our Infusion business. We continued to drive competitive conversions and upgrade our installed base. Pricing has been stable and even improved slightly during the quarter. In short, we remain on our plan for the year with a superior Infusion System that is preferred by clinicians in a strategic market.
Finally, the Respiratory Technologies business lapped its final quarter comparing to a strong prior year period where a government contract for ventilators had provided us with nice growth. The fundamentals of this business remain unchanged and we again saw growth in our Respiratory Diagnostics portfolio.
On a consolidated basis, revenue for the quarter was $968 million and adjusted earnings per share were $0.60. Adjusted EPS was slightly below the expectation we set on our Q2 call due to the slower ramp in Pyxis installations. But we remain committed and on track with the full year revenue and EPS guidance we provided at the beginning of the fiscal year. With one quarter to go, we are tightening our revenue range towards the high end on an organic and reported basis. We expect adjusted EPS to be at the low end of our $2.30 to $2.40 range, largely due to timing of the Pyxis product line transition.
Beyond the good progress we made operationally with the Pyxis transition this quarter, we are raising our cash flow guidance for the year, predominantly due to the strong cash flows associated with the Dispensing business. As I mentioned earlier, our large installed base of Pyxis leases provides a consistent cash flow engine. As we enter the fourth quarter and prepare to close fiscal '14, the core fundamentals of our business remain strong and we continue to make strategic progress. I see no change in the competitive environment and I believe our position continues to strengthen in medication management, respiratory consumables and in our other procedure-based businesses that address surgical and IV vascular needs. Although we saw pressure on margins this quarter, I remain comfortable with our ability to expand margins going into fiscal '15, meet our three-year commitment and go beyond our targets during the next several years.
Before I turn it over to Jim, I want to make a few additional comments about the strategic progress that we're making. Our Procedural Solutions segment has hit its stride and continues to drive organic growth as we reload the R&D pipeline and add new growth from partnerships and acquisition. In addition to the partners I mentioned earlier, we are off to a strong start with our Terumo relationship, where we exclusively sell the differentiated line of peripheral IV catheters in the U.S. acute care market. We've also seen an uptick in key product categories as our teams have taken a more consultative approach in helping our customers improve clinical practice. Nowhere is this more evident than with our ChloraPrep skin prep up which had another great quarter of growth.
In the Medical Systems segment we completed our investments of Caesarea Medical Electronics or CME, strengthening our long-term infusion strategy with access to faster growing segment of the market. CME's products align well with customer needs in several key geographies outside the U.S. and in ambulatory care within the U.S. More broadly, we have a medication management franchise with end-to-end products and services that are unmatched in the industry. Health systems are in need of solutions to help improve the safety and lower the cost of medication management and CareFusion is a differentiated part. We continue to make progress during the quarter with multiple new agreements that include both our dispensing and our infusion business.
Our balance sheet continues to be strong as is the pipeline we see of acquisition opportunities. We understand that you have an interest in our acquisition plans and I want to assure you our outlook has not changed. We will continue to operate with urgency and with discipline.
I look forward to taking your questions. But first let me turn it over to Jim for some additional detail on the quarter. Jim?
Thanks, Kieran. Today I am going to recap our third quarter goals and provide commentary on our guidance for the remainder of the year. As usual though before I get into the details, I want to highlight what I think are the major headlines from the quarter.
First, we continued to make progress across all business lines. Procedural Solutions sustained its mid to high single digit organic growth and it's on or ahead of schedule and deal models with both the Sendal and Vital Signs integration. In Medical Systems we had another strong quarter of committed contracts in dispensing and in Infusion and we are entering the fourth quarter with a record backlog that continues to grow.
Second, our cash flow continues to be very strong. Operating cash flow came in at $158 million in the quarter. That puts us year-to-date with operating cash flows up $455 million, which is 7% above last year and well above our expectations. As I mentioned in the past, this is actually an example of how our capital lease models can impact the financials in a way that it’s a bit disconnected from the fundamentals economics of the business. Specifically, while our dispensing revenue was lower through our product line transition and install cycle, the cash flows remain strong from our unchanged receipt of month to month lease payments.
Finally, we are still on track to be in our full year revenue and adjusted EPS guidance ranges that we started the year with in August. Organic product mix and lower margin acquisitions have pressured our margin, which we partially offset with lower expenses, putting us at the high end of our original revenue guidance and at the low end of our original EPS range.
Now looking at the consolidated results for the third quarter; revenue of $968 million grew by 7% on a reported and constant currency basis. Another quarter of solid revenue growth with Procedural Solutions that’s 25% as reported and 5% organic, was partially offset by a 2% decline in Medical Systems.
Adjusted gross margin for the quarter declined to 49.5%. This decline was really due to three things; lower margin acquisition of Vital Signs and Sendal, product revenue mix, in particular dispensing revenue, and the previously disclosed impact from one of our key suppliers winding down their business. These factors were anticipated and discussed on previous calls.
Adjusted SG&A was up 4% to $237 million compared to prior year, which was entirely attributable to acquired SG&A. Inflationary increases in SG&A, as well as go-to-market investments within the businesses were again offset by our ongoing cost savings initiative.
R&D spend was flat sequentially to the prior year as we continue to invest in both our Medical Systems and Procedural Solutions businesses. As we mentioned last quarter, we are hitting key product milestones in our Medical Systems segment and are shifting R&D funding to our Procedural Solutions segment to build out our portfolio of clinically differentiated consumable products.
Moving down to P&L, new to the income statement this quarter is the impact from our investment in CME, which we announced last quarter. It closed on March 1st. CME is an Israeli pump company in which we have a 40% ownership and account for using the equity method. So our share of their earnings is shown in the earnings of equity method investee line and that number amounted to $1 million in the third quarter. For modelling purposes, we expect this number could be approximately $1.5 million to $2 million in the fourth quarter.
Adjusted operating earnings declined 3% year-over-year. We did see approximately 200 basis points of margin compression, which as I mentioned was driven primarily by unfavorable revenue mix and our key supplier winding down their business. On a sequential basis, adjusted operating income increased 8% and operating margins expanded by 60 basis points.
Interest and other increased from prior year by $10 million, up to $27 million. This increase is primarily due to the settlement of a tax matter in connection with a foreign tax position for which we had a receivable accrued that dated back to the spin off from Cardinal Health. In settling the matter, we had to write off the receivable to the interest and other line as we released the reserve which benefitted our tax rate. These two items completely offset each other and had no impact on our net income for the quarter or for the year.
Our adjusted effective tax rate of 24.9% was better than expected due primarily to the tax settlement. As a result of the tax settlement, we are updating our full year adjusted effective tax rate to approximately 27%, which is roughly 100 basis points lower than our previous guidance.
Adjusted diluted earnings per share were $0.60. That's a 2% increase compared to last year and slightly below the expectations we set on our second quarter call. As already discussed, our continued strength in Procedural Solutions and focus on cost management was partially offset by the impact of our revenue mix, particularly from the dispensing.
Operating cash flow from continuing operations remained steady at $158 million for the quarter, $455 million for the nine months ended March 31. Our cash balance on March 31 was $1.3 billion, of which, approximately $1.1 billion is held outside the U.S. and debt totaled approximately $1.5 billion.
Wrapping up our consolidated results, we repurchased 2.5 million shares for a total of $103 million in the quarter and as of today, we’ve repurchased 11.5 million shares for $444 million year to-date within the fiscal year. This puts us on pace for the roughly $500 million that we guided to at the beginning of the year and for our diluted weighted average shares outstanding to be slightly below 215 million shares for fiscal ’14, just as we guided to in our second quarter call.
Now moving on to the operating components of the segment, Procedural Solutions revenue grew 25% to $397 million. That translates into 5% organic growth. Again, we saw balanced growth across all the geographies and each business lines. Infection Prevention was up 12% to $168 million versus prior year, driven by strength in our ChloraPrep product line as well as the acquisition of Sendal. Medical Specialties revenue of $91 million rose 3% compared to prior year. The Specialty Disposables revenue increased 75% to $138 million. Specialty Disposables was driven primarily from the acquisition of Vital Signs. We also did see another strong quarter from our strategic partnerships in that business. Most notably we had meaningful growth in our distribution agreement with Smiths Medical.
Moving to the Medical Systems segment; revenue of $571 million declined 2% versus prior year. Within Medical Systems, Dispensing Technologies revenue of $233 million was roughly flat to prior year due to the ES transition and implementation cycle. This is a significant improvement versus the exciting revenue that we saw in Dispensing in the first half of the fiscal year, and we continue to be encouraged by what we see in this business. As Kieran and I have already mentioned, we did have another quarter of strong committed contracts. We have a record backlog, which positions us well for future revenue growth. The increasing backlog has given us much greater visibility into our installation scheduled for this and the next several quarters and therefore better confidence in our ability to meet our updated fiscal '14 guidance which I will talk about shortly.
Infusion Systems revenue declined 3% to $238 million if we’re comparing to our strongest quarter last year. The impact of lower capital installations was partially offset by higher dedicated disposable sales in the quarter, which as you remember is the high margin revenue tail from our capital tail. On a year-to-date basis, Infusion was up 4%. We also had another solid quarter of committed contracts in this business and our teams are preparing for a record setting fourth quarter.
Finally, Respiratory Technologies' revenue of $94 million declined by 3% versus prior year, but we're still comparing to a prior year period that included a large government order. Though the tender driven portion of this business is always going to create lumpy results, we see the underlying business as stable in a flat to low growth market. And net of this government revenue from last year, Respiratory Technologies grew 2% year-over-year.
Now for the fiscal '14 guidance. As I've previously mentioned, we expect to be within our revenue and EPS guidance as we said at the beginning of the fiscal year. With one quarter remaining, we're raising the bottom of our constant currency revenue range and now expect 2% to 4% organic growth and 5% to 7% growth, including acquisition. We do have some adjustments to the composition of the results which I’ll get to next. In total, we expect these will put our adjusted diluted earnings per share at the low end of our $2.30 to $2.40 range.
We expect Medical Systems growth to continue to be in the 1% to 4% range that we previously guided to. With respect to components of that growth, we expect Infusion Systems to be well above that 1% to 4% range for the year and that both Dispensing and Respiratory revenue will decline on a full year basis, even though we expect both of these businesses to grow strongly in the fourth quarter. This reflects our current implementation schedule in Dispensing and Infusion as well as the visibility to the sales pipeline and tender orders within our Respiratory business.
In Procedural Solutions, we are raising our guidance range, 200 basis points to 4% to 6% organic growth based on better than expected results in all business lines. This correlates to reported revenue growth of 15% to 17% when including acquisitions.
Our adjusted operating margins are now expected to be approximately 20% as we've discussed since the beginning of the year. Our revenue mix is the key driver to our operating margin. The growth in our lower margin products and pressure from dispensing volumes led to the new guidance.
Finally, wrapping up our guidance, we expect capital expenditures to be approximately $100 million and we're raising our operating cash flow guidance range by $50 million to $550 million to $600 million. This is due to the steady cash flows that I mentioned earlier from our dispensing leasing model. Our cash flow demonstrates our market leading installed base is stable, with a record committed contracted backlog that we are well positioned in this competitive market.
Looking out just a little bit longer, at this point our three year guidance remains unchanged. We continue to expect organic revenue growth in the low to mid-single digits moving up to the mid-to-high single digit excluding acquisition and an adjusted EPS CAGR of 12% to 14% for fiscal '13 to fiscal '15. We're currently in the process of building our budget for next year. We'll give you more wholesome update on our August call.
In addition to a number of tailwinds in our businesses next year, we obviously know that capital deployment is needed to reach these targets. We continue to have a strong balance sheet that we can leverage via future acquisitions or additional share repurchases. This year you’ve seen us continue to put the balance sheet to work with our buyback program, the acquisition of Vital Signs and Sendal, and our investment in CME, and we're committed to continuing that through the rest of this year and into next.
So in summary, I'd say the first half, second half story that we talked about all year is playing out, perhaps just a little bit later in the year than we originally thought. We continued to make progress in our dispensing product line transition. And having being around this business for the better part of the decade, I really feel like we're turning the corner on the dispensing install and revenue cycle. In the meantime, our other businesses are having a remarkable year to help offset the impact of these installed timing issues. And I will say that the organization continued to respond very well to all the challenges that we face.
So with that, I say thank you and I think we can open it up for questions.
(Operator instructions). Our first question comes from Mike Weinstein with JPMorgan. Please proceed.
Michael Weinstein – JPMorgan
Thank you, Jim and Kieran. I just want to step back for a minute and maybe just understand two things. So one, just kind of what played out here the last couple of quarters that caused the margins to be a little bit light. Obviously there’s some mix issue. And the EPS turned up at the low end of the range. And maybe just step back, because I think it looks like it's a repeat of the last couple of years where we end up the year at the low end of the EPS range than we started out for the year. So can you just talk about that in the broader picture in terms of the visibility and predictability of the business and the challenge in actually forecasting on a short to medium term basis?
Yes. It's interesting, Mike. This is Jim and I’ll say a few words and I am sure Kieran will have a few to say. You think about the last couple of quarters what has changed. It’s really been around product mix. So you have had our highest margin business, the installs and the revenue cycle play out a little bit longer than we thought. And so the mix has gone against us in that business. What has substituted for some of that revenue are Infusion pumps which tend to be lower margin and then these acquisitions which tend to be lower margin. So where you end up with just from a mix standpoint what's really changed in the last 90 or 180 days is really around product mix. And we’ve offset some of that with better performance, with cost cutting measures, but we just couldn't -- you just can't overcome year-to-date having your larger, most profitable business being down year-over-year. It’s steep decline. So that's what's been driving the margins for the last couple of quarters and that's what driven and continue to drive the margins and EPS guidance down.
I will say also we have been investing a bit more in our go-to-market in our installed resources. And you've seen that play out a little bit as well as we're working through these new installs where we're investing, making sure that customer experience continues to be strong. And so you are seeing a greater level of resources and what are essentially higher costs full system installs versus upgrades in the dispensing business. So, just kind of flipping to the second part of your question which is over the last couple of years, we've seen that -- a similar thing play out. I would say, at the end of last year, you saw the first sign of this dispensing install cycle kind of catch up and that's what took our margins and our EPS down a little bit towards the end of the year. This year at the beginning of the year, that’s played out. It dragged on a little bit further. I really feel like as I said in my remarks, we are turning the corner on that. I think we are going to see some strength in the fourth quarter and next year in dispensing. So hopefully we're getting past that. I think it's a common factor, Mike that has driven both of these things and no change really in the key message.
Yeah. First of all, I appreciate the multiyear nature of the question. And I think it reminds us to maybe take a step back and look at this journey that we've been on over the last couple of years. When you think about what we took on three years ago and the amount of simplification of this business, the movement of where we spend money or allocate resources from non-customer facing areas to customer facing areas, getting and reengineering sales forces, reengineering products with offering such as Pyxis ES, which is really going to be groundbreaking as we move forward.
Personally, I think we've made an enormous amount of progress and I think that the team has a lot to be proud of. There's always some timing issues with that, right? So you can get some bumps in the road, which we always said would occur. And sometimes things don't go exactly as they play out, but strategically and fundamentally, competitively underlying this business we are a far, far more competitive business and much stronger than we were. Could we be a little bit better sometimes in the short-term forecasting? Yeah, and I take personal responsibility for that, but I think we've got a handle on the big strategic parts of the question.
Michael Weinstein – JPMorgan
And just a follow-up on the install question, is this, A, creating any issues at the customer level or at the install process? Is it, CareFusion is taking longer to get the install done and get them right because the system's more complex and is that the case and is that creating any issues? And do you maybe just help people with how realizable this order book that you've been talking about the last three quarters is going to be over the next year?
Yeah, great. So, the timeframe of installation, the reason why a time it has extended is exactly because we do not want to put customers through any bumps or grinds. We feel that to the extent that there are challenges, it's our job to take that on our shoulders and be able to relieve that from the customer. What we're doing here is, these customers are moving from size to scale. They may have, let's say five or six different hospitals that were operating very independently and historically the way that we and others in the industry would do installs is each individual hospital would be automated by itself and then there had to be a complex way of trying to knit those things together in the background that quite frankly was not nearly as efficient for the customers they would like to be as they try to operate their systems as a single system, those five hospitals as a single system. We allow them to do that today.
So the timeline that’s involved here are doing things like workshops with our customers, helping them because they are changing their processes. They are improving their processes and we’re helping them through that. So part of this is a learning curve for us in helping them through that process. I can tell you that the early installs and ones that we’ve seen over the last couple of months, they’ve turned into reference sites now. So we are sending other customers to them. They are that pleased with the progress that we have made. So I think everything that we’re seeing about this business is that it is healthy, that yes, there is a learning curve that we have to go through, but we’re helping our customers through it. They are very appreciative of that and we have turned them into reference sites. Jim?
And Mike, the second part of your question, how realizable is this backlog? I would say that it’s extremely realizable. I would say the vast, vast majority of our committed contracts turned into revenue and there should be no change in that. So we see very few cancelled sales orders. We’ve got a contract. It’s a legal document. The customer had said they want to buy our stuff. They wanted to install our stuff. It’s just a matter of getting in the schedule. So the vast majority of those committed contracts that comprise that record backlog will be realized. It’s interesting while we’re waiting to install, just keep in mind that’s one of the things that’s been somewhat of a frustrating experience for us from an economic standpoint, remember the vast majority of our placements of dispensing equipment are on a capital lease. The vast majority of those placements, so those upgrades for the ES platform, were upgrading people that already have our equipment and are paying for it month to month. So, if you think about the series of events that happened, we’re getting paid right now month to month for these leases. On the day we install, we will continue to get paid for what we've installed. The only thing that happens on the day of install is the revenue event, a book revenue event for the capital lease. And the fundamentals of the business are very strong, and the cash flows that you're seeing coming out this year are representative of that, but like I said it’s one of those things that we've been struggling with a little bit.
Our next question comes from Rick Wise with Stifel. Please proceed.
Rick Wise – Stifel Nicolaus
A couple of questions. Can you characterize any of the ES sales or installs, your initial experience? You've talked about some of the sort of related upstream software components like CUBIE ES and Pyxis Prep, et cetera. Are you seeing any adoption of the upstream, these upstream components? And how we should think about that as we reflect on your, it seems significant ongoing success of building a backlog?
Absolutely. So what the vast majorities of these customers are buying into is the whole medication management solution. And it's something that nobody else in the industry can provide, the way that we do. And so, it's funny. We just had a full day visit of a customer last week that I sat through most of the day with, great, multi many hospital customer. And we were walking them through this vision of medication management, which was entirely aligned with the challenges that they were trying to solve, which is how do they manage their inventory throughout the system. How do they prevent this three-sigma problem, which is the way that medications get treated from the day they come on the shipping dock to the day that they get administered to the patient, how do they minimize the risk that's associated with that through various tools and techniques which we can provide. How do they create connection all the way down to the institution? So from a strategic alignment perspective, we're finding that each of the solutions is standing on its own, because they have to.
So for instance the Pyxis ES system, customers are acquiring that because they believe it is the absolute best dispensing system in the marketplace. The Alaris customers are buying that, because it is absolutely the best, but they are also very excited and very aligned with – for instance Pyxis prep, which is a great example of the motor or the connective tissue that we are providing that connects those -- that process of medication management throughout the hospital. So the vision is being understood by customers. It is being adopted by customers. Our primary focus though at this point is to get the Pyxis ES customer and the backlog work through. And we're working with our customers to do that. And as I noted, those early customers quite frankly have turned into reference sites, which is exactly what we intend to do and what we had hoped for.
Rick Wise – Stifel Nicolaus
Maybe Jim, a question for you. Let me see if I can say this properly, but you know if the – one of the perspectives of recent quarters has been a sort of negative mix shift if you will. It's hard for me to avoid reflecting on the flipside of the story that if that volume mix shift trends back toward higher margin Pyxis ES sales, as Pyxis backlog turns into revenues, and alternatively maybe procedural growth normalizes a bit. Couldn’t there be surprisingly, maybe very surprisingly strong bump up in margin? Is that the right way to think about it? Can you help us maybe quantify that? I know you don’t want to give guidance, but how do we reflect to that the flipside of what we have been seeing?
Yes. Obviously you have hit on that already, which is we are not ready or prepared to give any sort of specific guidance for next year. Certainly one of the tailwind for FY '15 should be the Dispensing backlog which as we mentioned is a record and that should drive good revenue growth and therefore nice margins for us next year. One of the other revenue challenge though will be the acquisitions that we’ve made. Those are actually lower margin acquisitions. So that would have sort of -- both of those will be tailwind on the revenue line. One will be the tailwind on margin. One will be a headwind on margin. So, again getting very specific about next year, not ready to do that yet. We are building our budget, but you are thinking about it right which is that will certainly be a tailwind for next year.
The next question comes from David Roman, Goldman Sachs. Please proceed.
David Roman – Goldman Sachs
I wanted to come back to the spending side of the equation for a second. I know you talked about discretionary expense management in the quarter and that shows through very clearly both in the absolute dollar trend in SG&A as well as the ratio. Can you maybe help us walkthrough how much of that was your own discipline coming towards the end of the quarter as you saw the revenue numbers come in versus sort of a structural shift down in your spending levels?
I’m not sure I understand the difference when you say structural shift down. What do you mean by that, David?
David Roman – Goldman Sachs
I mean is this a new rate of SG&A spending or does is a 24 number where we should think about going forward or does that number ramp back up as the installations ramp as well?
Got it, okay. So I mean certainly we took action when we saw that we were going to have a revenue mix problem and therefore a larger problem. We certainly took action as an organization. The organization did respond. And so you are seeing what I would describe as a potentially temporary dip in spending to offset some of that. However, the objective is always for us to figure out a way to drive improving efficiencies, particularly on the SG&A line. So I would look for some of these lower trends to continue through the fourth quarter and then maybe next year it might pick up a little bit and grow with the business. Certainly in the fourth quarter, you'll always see an uptick in expenditure. They're commission driven. They’re distributor payment-driven. They're incentive comp-driven. So that will happen, but of course the fourth quarter is also a big revenue quarter for us as well. So I guess the short answer is for the remainder of this year, we'd like to continue, we will continue to see I think some very positive ratio SG&A to revenue number and then next year obviously we’ll give you guidance on where that will go for next year.
And underlying –that's all the short-term, underlying it, David, we had initiated as you know, a couple of years ago our CareFusion Simplification Initiative or CSI, which really is a longer term process of getting at structural advantages. That project has yielded very significant benefits. It will continue to do so. We're launching CSI 2.0, if you will, and that will be something that we're going to be working hard at over the next several years and we see some nice pockets of opportunity to continue that cost control process in a much more structural way.
David Roman – Goldman Sachs
Okay, that’s helpful. Then maybe Kieran, you did reference M&A in your prepared remarks and obviously there is quite a bit of interest in that both in med-tech as well as across healthcare. Maybe you could just update us on how the landscape is shaping up. There's been quite a bit of activity over the past quarter both with strategic and financially driven objectives, but any perspective you could provide on how you're seeing things play out in the overall environment would be helpful.
Yeah. So the environment's been playing out pretty much as we've been talking about here these last couple of years is which, this move towards consolidation. This idea that scale is very important, not necessarily just size but scale where you can get advantages throughout the business, either in call points, technologies or geographic expansion. We continue to be very active in looking at deals. Obviously this year, we've done several, several on the small side. Vital Signs I would consider more on the sort of the mid-range size. There is a lot of diligence you've got to do in these things. It's easy to -- there's a lot of garbage on the market too to be quite frank and things that wouldn't pass our thresholds of return. So, our intention is to maintain the discipline. You've seen that in what we've done. You've seen that our acquisitions have been highly strategic. We've done investments such as in CME. You saw that the – in fact with Vital Signs we’re already ahead of the deal model on that. We intend to maintain that discipline and there is a pipeline of attractive assets. You’ve just sometimes got to sift through some of the wheat and the chaff.
Our next question comes from Bob Hopkins with Bank of America. Please proceed.
Robert Hopkins – Bank of America Merrill Lynch
So, just to follow-up on that last question on M&A. What's your view on opportunities for M&A outside the United States? How is that looking right now and did you assess these acquisitions? Do you think there are opportunities for you to lower your tax rate as you look at some of the deals, if there's a good strategic fit or would you not have us focus on tax rate as a major opportunity for the Company over the next year or two?
So, when we look at M&A, our first threshold has to be one of the strategy, right. Does it make us a better Company? Does it help strengthen and provide scale in those areas of the business that exist today? Or is it an overlap, an extent where it gets us into some businesses that we think are attractive and where we think we bring something differentiated to that asset or to that market. So that is the primary goal. Certainly we have opportunities to expand on a global basis and many of the acquisitions albeit on the smaller side, but many of the acquisitions we've done have been either located outside the U.S. or have significant presence and I would include Vital Signs with that have significant presence outside of the U.S. So we continue to look and to evaluate opportunities on a global basis, either standalones or carve-outs or whatever form that they may take. I think your specific question on a tax rate has to do with the inversions that have been announced recently, particularly in the Specialty Pharma business, but certainly in other businesses. We are certainly quite aware of those transactions. We are aware of the benefits associated with that. We're aware of the other complexities associated with that. So I'll leave at that, but that's certainly part of the evaluation process.
Robert Hopkins – Bank of America Merrill Lynch
Great, appreciate that. So as a follow-up I want to just talk about margins. Your guidance for this year is obviously coming down about 100 basis points at the midpoint. And two things on that; one, I just want to make sure, in your view is that all mix or are there other little things going on here like are the margins on the companies you've acquired maybe not quite as high as you thought they could be? And then thinking about margin opportunities long-term, when you guys report your fourth quarter, are you going to update us on your three-year operating margin guidance this summer? And how would you have us think about it from a qualitative perspective about your long-term operating margin opportunity given the moving parts you're seeing right now?
Yeah. So the first thing is on the margin – the guidance change, it's largely two things. I mean, there's always a million puts and takes that are with a lot of numbers to the right of the decimal point; but since the last time we've spoken which is what you're really, I think, referring to, it was all product mix. The acquisitions are part of that. The Dispensing revenues are a part of that. And it's also a second thing which is, as we mentioned in some of the remarks in some of the earlier questions, we are investing in some of these -- in the installation resources in our Medical Systems side of the business. As I mentioned, we've got higher costs, full system installs versus upgrades. We've got a new product line, a more deeply integrated installation. So we are investing to keep, as Kieran said, the customer experience at the level that we feel is appropriate. So, really two things, product mix. Acquisitions are part of that. Dispensing is part of that.
Those are the two biggest pieces and then investment in these installs, making the investment in the installs. That's really what's changed since the last time we spoke. If you think about us and our margins order, we’re taking a big step back and say, gee, in fiscal '11, SG&A was 30% of sales and this year it's trending towards something more like 25% of sales and where could it possibly go? Margins similarly are up, I don't know, 300 basis points, 400 basis points at that time or something along those lines. I don't have the numbers in front of me. Is that trend despite the bumps we've had this year, can that trend continue?' I think the answer is TBD; but certainly, we've got the opportunity. And so, this August or shortly thereafter, we'll absolutely give an update on our long-term margin targets.
We've just initiated the second wave of our CareFusion Simplification Initiative, what we call CSI 2.0. Within that project you've got a number of sub-projects, things around the global shared services, manufacturing footprint optimization, our order to cash process harmonization, our global system harmonization, global data standardization. And we’ve got pricing project in there, customer experience project in there. You add up all these things, these are bigger, deeper harder to get at benefits, the things that fundamentally and structurally change the way we do business. There’s a tremendous opportunity there and it's certainly in the order of magnitude of what we’ve seen from some of the work we’ve done in the past, these are very big opportunities. So we will give an update. We will give a three year margin target at some point in the future, probably in the August call. We'll update on what we have accomplished so far and what we think we can do going forward. There is a lot of opportunity with these projects.
Our next question comes from David Lewis with Morgan Stanley. Please proceed.
David Lewis – Morgan Stanley
Kieran, I wonder if you could step back. I know there is lot of questions on dispensing this afternoon. But can just back out dispensing, broader med systems was weaker in the quarter. And I think if we go back the last six quarters, your med systems business has been negative organic growth. Maybe just take a step back here for a second and give us a sense of what do you think is the structural growth rate for the Medical Systems business and how much of this is just inappropriate product timing or how much of this is just U.S. market pressures? Because your relative share has not been the issue. So I wonder if you can just help us understand what has been the issue here over the last six or seven quarters and where can this business be over the next 6 to 8 quarters?
So I think fundamentally, the Medical Systems business, we've really transformed it over the last several years as far as how it is competitively positioned. How we leverage each piece of it instead of competing on an isolated basis, but rather competing across the spectrum of the businesses. And you are absolutely right. There is some market forces in there that are always going to create some level of headwind for us. So I think the – let's take a wider category. I think in the Respiratory business, lapping of that government order and sort of wearing that through put a lot of pressure in particular on the Respiratory business. But the Respiratory business in general doesn't have the same strength and the advantages from an industry dynamics that we see in Infusion and Dispensing. So I think by its nature that's going to be a business that is a relative slow grower.
It's going to have lumpy times where it's really good, when you do well in some large government contracts and there will be some times when it’s a little bit behind that. But fundamentally it's a good contributor to the bottom line. It is a good cash flow generator and it helps feed the engine growth to other parts of the business. So it knits together well and quite frankly we think over time we can make it a stronger business by integrating it into the informatics backbone that we are developing throughout MS. That customer I was talking about just a couple of days that was in, just top of mind for me at the moment. But in speaking with them about the Respiratory knowledge system and how we can change the way that the weaning process occurs as an example, it excites customers but it’s going to take a couple of years for that to really show the benefit that's going to drive the top line.
I think the fundamentals in Infusion and Dispensing are much better. I think you want to sum it to where is the growth opportunity, I think in that let's call it mid-single digits is where we would tend to target that growth. Infusion we remain a very viable and strategically attractive company. We have not only a pump that is exactly aligned where the customers are looking for and driving safety, particularly in times when they’re reducing nurses, operating nurse count per patient. The opportunity for error to be introduced requires that you have systems that are smarter that allow you to envelope them in more of a safety protocol. But it also requires that it becomes a node in the system of care that integrates into the backbone of the HIT systems. The Pyxis ES, we haven't even begun to see the benefits of this. We are in the early days which are the toughest days because it's hard to predict exactly the learning curve ramps. And again I think if there's anywhere that we’ve fallen apart here is that we could have done better job in helping and being able to communicate that ramp and quite frankly being able to predict the early parts of that ramp.
But I'm telling you that business is solid and it resonates with customers. So I think basically what you're seeing is us transforming the marketplace and how you go to market, moving away from these isolated verticals and showing that is really about processes and systems and then identifying the white space in the between those. So you put all that together, I think particularly in the medication management side of this business, you are going to see strength. I think the mid-single digit is something that is quite reasonable. And maybe more than that, it gives you the opportunity to jump in to other parts of the business, whether it's some of the data oriented parts of the business or whether it's leveraging the relationship that we have to those to the world medication management like we do with our chemo safety product. I think you are going to find that the halo effect is quite strong, very valuable and very profitable all the time. Jim, do you have anything to add to that?
I think that's right. I think we’ve had a strange six quarters optically where we're comparing in respiratory to a big tender offer. In Dispensing, we've had this product cycle conversion. Infusion has been strong through the period, obviously, a huge year a couple of years ago with the Baxter conversion. So, it has been a bit of a strange couple of quarters, David, optically. I absolutely agree with that, but I think everything you think here is right, fundamentally about the businesses.
David Lewis – Morgan Stanley
Okay, and just a quick follow-up, Jim, I'm just trying to set the expectation appropriately for next quarter. I know you've gotten some questions around the perfect year. But by next quarter as we get the next three year outlook, you've talked about the last several quarters, this dynamic of it. At some point, we have to make a decision on a significant buyback or obviously a much more significant acquisition. Is it a realistic expectation that when you give the guidance for fiscal '15, we're going to get an announcement on the buyback or obviously some acquisition could happen at any time? What happens if we get to that point in three months where we don't have that deal. What is your outlook and guidance going to be as it relates to the buyback? I'm just trying to set the expectations appropriately.
That's a great question and it's obviously one that we're – we understand that we're dealing with – first of all, we've got the balance sheet in order and we've got the firepower to get to where we need to get to. The question is, how and when do we make the decision, how and when do we make the announcement? So, in the next 90 days, we're certainly looking at a number of good scenarios. We've got a number of different acquisitions we're working on that would alter our decision on the buyback and we just need to let those things play out. Certainly at the next earnings call, which will be August, you will get a much more detailed, fulsome update on what we expect to do for the year. By then, we'll have a better sense of what's in the realm of possible from an acquisition standpoint and then we'll lay that over top of our share buyback and let you know what our assumptions are. So it really comes down to how much and how aggressive do we get on the share buyback and that plays in relation to how close – how we announce the deal, how close are we in announcing a deal and how big is that deal. So, there's not a real definitive easy answer right at this second, but certainly we will have much more clarity in 90 days. We'll have to because we'll have to have a plan for next year and guidance for next year that we give you, and a plan that we've got to approve internally as well.
Our next question comes from Matt Miksic with Piper Jaffray. Please proceed.
Matt Miksic – Piper Jaffray
I did want to go back into Dispensing for a second, just to understand maybe, Kieran, if you could help me understand, I guess, how you're balancing these additional investments you're making in implementation versus your cost optimization efforts in light of, I guess, the way that you had previously looked at your long-term margin targets. It may be helpful to gauge how you're prioritizing those now given that you have those sort of swell of implementations you want capture with the appropriate level of complexity and customer experiences you've talked versus trying to hold the line on that cost structure. I'd love to get any additional color on that, and then I have one follow-up.
Sure. So the basic answer is that the surge in resources that we're putting in place to make sure that the customer experience is as absolutely positive as possible and that we can come up to a learning curve as quickly as possible really don't have any effects in our long-term plans or even our medium-term plans around other areas that we are investing in or where we’re controlling costs. Jim went through a good list of some of the things that we are now in the planning stages of and some cases in the early implementation stages for system-wide improvements in our cost structure and simplification of the business. And these are changes which will likely yield tens and tens of millions of dollars in savings that can be applied back in the business. So the pedal is not coming off that accelerator one iota, because of this investment in these businesses.
So I think it's good to mentally separate those two things. And with regards to, again, the Pyxis implementation, a lot of this is just about learning. It's about how you run the meetings and what resources you pull in from the customer to make sure that they are prepared for the changes that they need to make. It's about using some e-learning techniques and some scalable ways of communicating as certain questions arise and we see that there are common questions. It is truly -- the way I would think about it is just a learning curve that we are going through on this. Over the long haul, will there be a few more resources that we'll put in place? If we think that improves the customer experience, we will keep them there because this is all about building long term franchises and these are very, very profitable businesses that we want to maintain our leadership at and we will maintain our leadership.
Matt Miksic – Piper Jaffray
That’s helpful. And then a follow-up Jim on your earlier comment about, I guess, mix of some of the acquisitions you made and as we think about the variables around a larger deal or other sort of mid-sized deals in your M&A strategy. I think we all appreciate your ROIC discipline that you talked about in the past. But should we be thinking about some similar kind of balance or trade-offs over the long term in terms of margins and growth as you get towards a bigger deal? Should we be thinking about the sort of the intermediate term impact of what the margins – as you capture synergies of this or push some of the horizon of your margin goals out further potentially on a larger size deal?
That is a great question. It's really relevant given where we are today. I mean certainly the deals we've done this year when you look at particularly at the acquisition we made of Vital Signs and Sendal, net-net if you sort of just, everything else being equal in the first full year – first full year of it will be FY '15, you are probably talking about approximately 50 basis points of operating margin pressure. So that creates a higher bar for us to get over, to get to our target of 21.5%. We said if you remember a couple of years ago, we did 21.5% exiting '14, then applied 21.5% for full year '15. That creates a little bit of a headwind to get there. So, I think when you think about going forward, I mean first of all, the perfect deal for us is one that's growing faster than us, that’s accretive to margins and is trading at a lower valuations. Of course that deal doesn’t exist. And so, you’ve got to balance those things.
When you look at Bioscience on a standalone basis for the first couple of years, it is a lower margin business, but the returns that we’re going to drive from this thing far exceed our weighted average cost of capital. So the ROIC in years two, three and four are really strong and the financial is really what we put the most importance on. So, we’ll see some more solutions this year. We will see some next year. And then as we get the synergies drip through, we’ll start to see the margins improve, get back to the corporate averages. Meanwhile the ROICs are very, very strong. So, that was a compromise that we intentionally made. Is there something from this that you can then apply to future deals? I don’t think so. I think each deal is very individualistic.
We are looking at something that will be accretive to margins. We are looking at things that might potentially be dilutive like Vital Signs, but ultimately with higher returns. There are some things we’re looking at that are growing faster than us, some things that we looking at that are growing at approximately the same rate. So, again there is no set formula. The first thing as Kieran said is, is it a strategic fit? Why are we a better owner of these assets? Second, the financials, the most important financial metric is return on invested capital. And then we try to look at things like earnings margin and growth accretion. So again, I don’t think there is a set formula here. It's just something that happens on an individual deal basis.
I think we're at top of the hour. Let's take one more question, and then I'll give Kieran just a second to give the closing comments. So, last question, operator.
Our last question comes from Larry Keusch with Raymond James. Please proceed.
Lawrence Keusch – Raymond James
I just wanted to circle back on the capital allocation plans. I think we all appreciate the challenges associated with executing on M&A. Clearly deals take on lives of their own. I think we also appreciate the potential to increase your share repurchase should you not be able to execute on the M&As as you had envisioned a couple of years ago. But I guess the two questions are, again, you've got 14 months to go before the end of your fiscal '15. And truly, how should we think about the commitment and ability of the Company to meet those capital allocation goals that you set forth a couple of years ago? If it goes in the direction of share repurchase, you've got $200 million in cash sitting in the U.S. So again, what mechanisms do you use to be able to go ahead and actually execute on that share repurchase?
Sure. So first of all, in terms of our commitment and ability, we're absolutely committed and we're absolutely able so that we should put those behind us. The $200 million of cash in U.S., that is correct. We've said that -- but we have said some things in the past. The first is, that we would anticipate funding the Vital Signs acquisition with a debt deal with permanent financing in place. In addition, we've got bonds that are maturing in August. So at some point you should look for us like we do another issuance of debt to take care of both of those things, sometimes coming up in the next couple of months. That will put more cash in the bank here in the U.S. which ultimately will go to M&A and or through share buyback.
In terms of making the decision between the two, it is as I mentioned on David's question earlier, and you mentioned it here, the inherent predictability of M&A makes it difficult, although we know within the next 90 days we need to make a commitment to our capital allocation for at least the beginning part of our fiscal year next year and let's get that approved internally, get set on our path and get it communicated externally. So, you will be hearing from us. Obviously our preference has been and continues to be value accretive M&A that makes us a more strategically valuable and better company. But having said that, we certainly have the ability and the willingness to put back through share buyback, if there are no deals that are obviously imminent for us in the near future.
Lawrence Keusch – Raymond James
And then just secondly, you've obviously talked a lot about the committed contracts and the backlog and it's impressive at your add record levels. But any thoughts on sort of how the continued committed contracting process is going? Are you continuing to see the strength and capabilities of the ES system continue to resonate with customers? And should we expect again that this isn't just a three quarter process, but this contracting progress can continue to have legs as we go into '15.
No, if anything, it builds on itself. So I would encourage us to think about the whole medication management strategy, because one of the other things that we look at certainly is how often do you have deals where either together or within a very short timeframe we contract for both for instance Infusion and Dispensing, because it indicates how customers are trying to build their entire medication management process around the capability that we can provide. And what we found year-over-year as an example we’ve had between the doubling and tripling of the number of deals that have been contracted for us, that would be considerably what we would call our combo deals, enormous amount of strength buying into that to that medication management strategy.
The second part is you actually have laggards if you will, and I don't mean that in a negative way. You have certain customers which want to wait and see how a system is rolling out and how it's implementing before they want to contract for it. And so that's why the establishment of these reference sites is so important. People not only want to see other customers that are using new technologies. They want to see customers that look like them. So are they a big multi-system hospital? Are they a hospital in, I don’t know, the Midwest? Are they a small community hospital? They want to see installations where they can look and say, okay, that looks like me and that's exactly the way that we want to drive efficiencies or we want to drive improvements in patient care throughout the system.
So I think what we are going to see and certainly the way that has dealt with and the way that the customer interactions are moving is that strength building on strength building on strength. So I think we actually have gone through the difficult period and what we are seeing ahead of us is how we leverage that. And then once we get those installs in place, there was a question earlier about the motor, about the connective tissue or that – the software such as IV prep. As you get more of these ES installs and the Infusion installs that work together, you start seeing and filling in that white space and those gaps in between. It offers us more opportunity to link even more closely with those customers. So from a strategic perspective and from a momentum perspective, I think we're in a very good position.
Sorry, we ran a little bit long. Kieran, any last comments you want to make before we wrap up?
I think first of all, I appreciate everybody's interest and questions. I know that – again, I will say that, if you look at the business right now, it is incredibly strong. I know that we could have done a better job with you in forecasting the ramp of the learning curve. So that, I take that on my shoulders, that we should have done a better job on that. But that being said, it is truly just about that ramp on the installs, all the categories that we look to, which is the committed contracts, et cetera, the nature of turning these early customers into reference sites, all the signals remain positive. And I don't want to – with all this discussion on the Pyxis ES, I don't want to lose the fact that the Procedural Solutions side of the business is also doing extremely well.
Now, we look back a couple of years ago and you recall the changes that we were going through there and we had a lot to prove to ourselves and to you about our ability to turn that business around and create a growth engine out of it. And what you've seen here is now nearly two years of consecutive quarterly organic growth in the high single digits in that business. So, very proud of the team throughout the entire Company, geographies in both Procedural Solutions and Medical Systems segments and in the functions that support them and help to be successful. So I want to thank the CareFusion employees around the globe and throughout the Company for their continued efforts and focus on the customers. Thanks everybody.
Okay, thanks everyone. Appreciate it.
This concludes today's conference. You may now disconnect. Have a great day.
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